The Truth Machine

It’s becoming more common to hear the Bears calling for a big drop.  Why do they say that?  Well, first they hope to be right, which earns a lot of street cred.  It’s an easier call to make because risk increases as asset prices move higher.  Stocks have come a long way from the first quarter of 2016 (not to mention ’09), when markets reacted very poorly to the Fed’s first interest rate hike.  If you timed it right and bought the S&P 500 on February 11, 2016, you’d be up over 35% in price return alone.  That’s a pretty big move in less than 18 months.  So, yeah, you might feel really good about calling this a top.

Bear markets are a real part of the cycle, and the Financial Crisis made that fact unforgettable.  Maybe that’s why more strategists are telling us to look over our shoulders.  Wall Street firms were repackaging subprime mortgages into new investments to sell, and then they repackaged those repackaged investments and sold them again.  It’s dizzying, and it flew under the radar until things blew up.

What if we had some way to keep things in check?  Well, born alongside the Financial Crisis was a new technology, one which in a sense is like a truth machine.  It may not have prevented the myriad of derivatives created from sub-prime debt, but it could have helped in other ways.  Let’s take look at recent economic and market data to help us get a better sense of where we stand today, and we’ll return to the truth machine.

US ECONOMY

Overall economic data continues to be mixed however the data is broadly more positive than negative.  Second quarter GDP was revised up to 2.6%, and consumer confidence increased to 118.9 while consumer sentiment dropped a few points to 93.1.  Housing data is mixed with existing home sales slumping a tad recently, however starts rose to 1.2 million.  The housing market in many parts of the country is underbuilt so it’s not a surprise that home prices have continued to drift higher.

The labor market remains strong even though unemployment inched back up to 4.4%, and Americans are unusually positive on the job market.  The consumer confidence survey offers insights on attitude toward jobs, and we’re up at a 16-year high as can be seen in the chart below. 

This kind of optimism is a big plus for the economy, but you also might wonder how much better the jobs market can get before an eventual slump shows up in the data.

The main source of economic uncertainty has been politics as investors are now questioning the reality of the new administration’s electoral agenda.  The GOP failed to repeal Obamacare in July, and Senate Majority Leader Mitch McConnell quickly declared that it was “time to move on.”  President Trump’s Twitter feed suggests that healthcare will not be an orphaned policy priority, but most expect the focus to shift to tax legislation.  These uncertainties that have also caused recent weakening in the US Dollar, which is probably a good thing since it has strengthened so much in the past few years.

INTERNATIONAL

Improving economic and earnings data in international markets are helping drive international equity markets upward, too.  European and Chinese manufacturing data showed healthy activity although China’s numbers slowed a bit, and Japan’s Tanka survey of business confidence reached a 3-year high.  The largest economies across the globe are now showing coordinated growth in 2017, and like the U.S. the looming risks are political and/or legislative.

The troubles continue for Venezuela as the U.S. instituted a ban on Venezuelan oil in order to punish the corrupt President Nicolas Maduro.  Venezuela is one of the most commodity rich continents on the planet, but leadership and a stable government are lacking.  Nearly a year after the historic Brexit vote, the U.K. has acknowledged its financial obligations to the European Union.  The initial estimate is to the tune of €100B, but that number will be the subject of debate.  Aggressive shows of force are also becoming more common between the U.S. and North Korea, and tension remains high.  Lastly, the Russians can’t stay out of U.S. headlines, and the U.S. is set to slap a new set of sanctions on Russia for 2016 presidential election interference.

STOCKS

The major U.S. benchmarks all continued their uptrends, and a few new all-time highs were sprinkled throughout July.  The forward 12-month price-to-earnings multiple (P/E) for the S&P 500 is 17.7, which is above the 5-year average of 15.4 and the 10-year average of 14.0.  Close to two-thirds of S&P 500 companies have reported earnings for Q2, and the blended earnings growth rate is at 9.1%.  How’s it happening?  Well, companies are increasing their revenues, and they’re utilizing technology to improve sales.  Companies are leveraging tech to figure out what business strategies aren’t working.  Think about it.  If you can reduce the amount of time you spend on bad business strategies, then naturally you spend more time on good strategies, and time is everything.

Looking forward, dollar softness and coordinated global growth offer a couple of tailwinds for stocks, and corporate tax reform could play a big role catalyzing the next leg up in markets.

CENTRAL BANKS

At the beginning of 2016, many economists predicted tightening monetary policy from the Federal Reserve while the rest of the world remained loose.  This was called Policy Divergence (sounds serious, right).  The Fed prediction has been accurate as they will continue moving rates higher at a cautious pace.   Meeting minutes from the Federal Reserve’s June meeting revealed a split among policymakers on the timing of balance sheet normalization, while suggesting the bank plans to maintain gradual rate hikes.  The USD fell to its lowest level in over a year after the Fed signaled its balance sheet reduction would start in the fall.

The European Central Bank recently messaged that it will discuss tapering its stimulus program this fall, and global growth may cause more countries to follow along with similar tightening policies.  However, some countries remain entrenched in loose policy.  For example, the Bank of Japan increased bond buying early in July, and they show no signs of slowing.

The new realities of central banking have created some volatility in bond markets.  Yields remain quite low, but they are poised to move higher.  It is also worth noting that the Obamacare Repeal failure left the Medicare excise tax of 3.8% on net investment income in place.  Municipal bonds may appear more attractive for the near term, but that all depends on what a new tax bill might mean for taxpayers.

COMMODITIES

It’s been a bumpy ride for oil, but reports from early July showed big draws on inventories and the month started with a small bounce in crude.  However, OPEC compliance to its own supply cuts fell to 78%.  Oil-dependent countries are really struggling so any short-term bump in prices has made it difficult to maintain compliance.  Following the likes of Saudi Arabia, Abu Dabi is now looking to sell a portion of the state-owned oil company via IPO.  The writing is on the wall, and the sustained glut has BP CEO Bob Dudley planning for $50 oil for next 5 years.  Oil prices showed strong correlations to the S&P 500 in recent years, but that is now changing.

THE TRUTH MACHINE

Bitcoin became the first cryptocurrency, and now its blockchain technology is what some have described as a truth machine.  Explaining Bitcoin is very technical, but ultimately, it’s very similar to modern banking in that it relies on your faith in a third party to account for your money.  For example, John has a regular job, and his employer pays him.  His employer makes a direct deposit into John’s account for the salary due.  John trusts a bank(s) to facilitate the transaction only knowing what he sees when he checks his account online or through the bank app on his phone.

Bitcoin went a step further, creating a system where all users see all accounts.  The term “blockchain” is used for the technology where the transactions are recorded and maintained.   Accounts are anonymous, but every user can see and question every single transaction, leaving little room to cheat.  The transactions are recorded on e-ledgers, and those e-ledgers become nearly impossible to manipulate.  That’s where things get very technical, and you can read the detailed explanation HERE.  It’s like a technofied honors system.

Cryptocurrencies get a bad reputation because they’ve been associated with seedy activities on the dark web.  There’s been some major volatility recently for those reasons, but there is real progress being made to normalize the use of cryptos and blockchain technology.  And some like the cryptos because they simply don’t like the major currencies backed by countries with massive debts.  The appeal of cryptocurrencies lies in allowing you ultimate control over your money, with fast secure global transactions, and lower transaction fees when compared to all existing currencies.  The future of blockchain is unpredictable, however the technology holds massive potential with applications in the cloud, digital identity safety, payment processing, voting, land registries, and maybe even tracking taxpayer dollars.  Surely, the field of play will evolve so stay tuned for updates.

DISCPLINE

The presidential election started what many have called the Trump Rally in stocks, but there’s been more going on under the surface.  The S&P went through a rough patch of negative earnings growth from the beginning of 2015 through Q3 2016, but we’ve now turned a corner and are looking at 2 going on 3 consecutive quarters of earnings growth.  Let that sink in… three quarters of earnings growth without any help from legislation.  We can give credit to election optimism however, as “animal spirits” helped markets to trade higher alongside earnings data and economic reports, and now we’re logging new all-time highs on a regular basis.

Enter stage right: the Bears.  We’ve written about the “unintended consequences” of interest rate manipulation (a la QE) and the trillions of sovereign debt across the globe.  Generally, low interest rates do mathematically send prices higher for risk assets.  You could look at all-time highs and the geo-political uncertainties, and you could decide to join the Bears, but we suggest you take a step back for a moment.  First, regarding all-time highs and rich P/Es, remember that averages are just that… averages.  Everything fluctuates: GDP, inflation, unemployment, and P/E multiples.  There are stretches of time where the multiple goes low and stays low (think ’08-’09 time frame), and there are stretches of time where the multiple increases and stays above longer term averages (we’re there now).  The Bulls say that momentum is in favor of stocks, and most major central banks are still accommodative with plans to very slowly normalize monetary policy (keywords “very” and “slowly”).  Second, regarding geo-political events and those that might worry about something like a massive attack from North Korea, let’s go back to 9/11.  Markets remained closed for several days following the attack, and the first trading day that opened saw a 7% decline in stocks.  However, within a few weeks the S&P 500 was back to pre-9/11 levels.  No one could have predicted it, and you didn’t have to wait that long to recover from it.

How do we move forward?  Acknowledge the risks but don’t ignore the data.  Eventually, markets will broadly turn down, but economic and business conditions don’t change overnight.  Be focused; be consistent; and remain disciplined.